Facts & Perceptions

As market participants, our actions are driven by primitive emotions of greed, fear, hopes and herd instincts. The internal battles, between our reptilian brain and our neocortex, are the engines powering the stock market and giving it its impetus.

While a utilitarian rational brain would command to buy more when prices are falling, most market participants prefer to buy rising prices or sell when prices are falling. Without emotions there would be no action. Without action and emotional inefficiencies, there would be no market. Man’s "failabilty" is the source of progress.

For every stock you want to buy, you need to find a willing seller. For every stock you want to sell, you need to find a willing buyer. You need two to make a market, like you need two to tango.

If one accepts the idea that in a closed system where the money in circulation does not change and where taxes and commissions can be ignored, any trade is a zero sum game, that would mean that for every winning trade you would effectively need a sucker on the other side. Of course, they are no willing losers in the market. Most market participants act with their self interest and self preservation in mind, such that the key reason to go on the other side of the trade, might well be a simple matter of perspective.

A day trader would be happy to take a profit and sell to long term investor who would look to accumulate for the long run. The same long term investor might want to buy a growth growth, which the short seller would be happy to sell as part of its portfolio hedging strategy.

These different  perspectives are the very reason markets exist, but don’t stop there. They also reflect our imperfect knowledge of  reality. We only see fragments of that reality while our conscious attention can only focus on a very small corner of that reality at any single time. This tends to distort one’s focus and attention. As Charlie Munger likes to remind people, „to the man with a hammer every problem looks like a nail“. A value investor would focus on certain criteria, while the trend follower would focus on others. If the stock market operates like a beauty contest, it is worth recalling that beauty lies in the eyes of the beholder.

To add to the complexity, reality in market is not static. A share price is not looking at the past or present but at a more uncertain and ever changing future, a future that is shaped by our collective visions and social moods and their capacity to shape our reality.

Back in the nineteenth century a shoe company sent two salespeople to India to assess the market opportunity or so goes the story. After a few weeks, the first one wires back: „nobody wears shoes: there is no market!“. A day later, the second one telegraphs „nobody wears shoes: huge potential!“ Clearly, both salespeople saw the same things, but their different interpretation of the same reality was effectively a matter of perspective.

As Churchill once said, "an optimist is someone who sees an opportunity in every calamity, while a pessimist is someone who sees a calamity in every opportunity". In Chinese, the word crisis and opportunity is the same.

This is obviously the key dimension that separates social science from physics. In the physical world, an action produces a clear predicable reaction, a fact is always the same fact that unfolds independently of any statements that relate to them.

In the social world, the same action can produce different perceptions and therefore different reactions and is subject to many more distortions. Social events have thinking participants whose decisions greatly influence the course of events, not independently of phenomenon, but as active interactive participants. The same text can be interpreted differently depending on the context.

In a social world, a perception can become a fact and a new fact can change perception, the same way a perception can influence the facts. This constant feedback loops between fact and perception is creating what George Soros (one of our many heroes) name „reflexive“ loop, the type of self-reinforcing/fulfilling circular reference at the heart of every major bubbles (like the tulip bubble below or bitcoin bubble recently) and also explaining one the paradoxes of risk.

One could well imagine that if the shoe company had followed the second sales person‘ advice and started converting local customers to the idea of wearing comfortable shoes, the vision would have probably eventually become reality. In fact, all great inventions start like this, a vision of the future that has yet to be embraced and adopted by the masses.

The internet bubble sucked a lot of money from investors but the perception of what the internet could be, helped raise the billions that eventually created the infrastructure that made it a reality. A company burning cash like Netflix can still attract investors lured by its growth story, while the high price of its shares does give the company a currency to buy the content and the earnings it cannot produce on its own. These types of reality distortion as Steve Jobs named them is how perceptions become reality. 

Greece came out of the Great Recession in 2011 like an emperor with no clothes. As long as the market was happy to lend to its government, its EUR-denominated government debt was strong and the country could borrow cheaply to finance its deficit. However, when the perception changed, its credit spreads spiked, its interest burden surged and its debt ballooned. The perception changed the fact, which in turned changed the perception, in a death spiral that led the countries to the brink of default. 

The emperor had no cloth and the bond vigilantes by stating it loud helped the market wake up to the fact. However, had the market decided that the emperor had clothes, then it would have given the emperor the time to sell its invisible clothes and get the money to buy real clothes, which is pretty much what happened when the German emperor accepted to lend some of its invisible clothes to its Greek cousins.

We cannot see reality as it is, but only a reflection of it. We fill in a lot of blanks with our minds and rely on incomplete perception of reality as the basis of our decisions. A man sees what he or she likes to see based on their particular emotional and physiological state. Perceptions vary from person to person. The same person can see things differently over time. Even the same painter can paint the same subject over and over again, yet never produces the same painting. We also assign different meanings to what we perceive. Therefore, with time, people change their perspective of reality or simply give it a different meaning. Reality is all relative and a matter of perspective. Beauty is in the eye of the beholder. This famous picture by Toulouse-Lautrec is either a a young or an old lady depending on how you look at it. The picture hasn't really changed, what changes is how your emphasis of certain traits assigned to them different meaning.

For the investor, the challenge is manyfold as it requires not just be sure of the facts, but also be conscious of opinions and  how these facts are perceived by the majority and social moods can change the reality of the facts. As a result, an investor should never assume, never predict and never trust information at face value.

The job of an investor is to ask questions. The answers may change, but the questions are always the same. Those who know all the answers generally do not even understand the questions. In a survival game, only the paranoiacs survive. So keep on asking questions and challenging the consensus.

As discussed in our previous post, 

always look at your investment cases from the opposite side of the trade. If you want to solve a problem, said Einstein, „invert, always invert“. When we want to buy a stock, we first look at the reasons to sell it. If you can’t find a good one or selling appears too risky, then it’s probably a buy. The reverse applies to shorts.

There is no facts, only interpretations, only perceptions. Even earnings are opinions.  Cash might be seen as a fact, but it can also be manipulated. That is why an investor should cherish diversity of views and look for people thinking outside the box, looking at things from different angles and acquire different perspectives. Never forget that every information is a creation and a reflection of a tiny piece of reality.

As such investing can be approach like a puzzle or a game of bridge, where the game is to gather clues of a more complex reality in order to see the full picture. Here, there are different strategies. Our preferred approach is the one used by eagles,which look at the big picture from far above, start seeing patterns, get a bit closer, start to narrow down the patterns, get a bit closer and eventually focus on the prey before striking. This is a top down approach. However, the opposite approach works well too. They say the devil is in the details, such that sometime an individual situation can reveal a bigger theme, like a tree can hide a big forest.

The key is to use as many mental models, what Charlie Munger calls a latticework of mental models to filter through the tons of data and opinions and narrow it down to some of the essential traits that would fit your criteria. It is not the answers that count, but the quality of the questions and the quality of the filters. As the answers may change, never stop questioning.

In the absence  of independent objective criterion, all decisions are based on bias and distorted perceptions of reality and lack of perfect knowledge. Therefore, market participants must rely on two functions: the cognitive one (logic based and fundamental based) and the manipulative one (opinion based and perception based). Therefore, it is key to always check the facts and the sources we use as the basis of our opinions and always remember that things are rarely what they seem and the world is at it is and not as it should be.

One should therefore avoid looking at the world with prejudice and other self limiting beliefs and avoid listening to "theorists" or opinions based on biases rather than facts. 

The list of behavioural pitfalls that tend to distort perceptions of reality  is a useful guide of what to be on look out, not just to avoid falling victim of other people’s narrative fallacies but also to keep one’s own perception of reality in check.

Biases (preconceived ideas, prejudice) - weighting recent experiences more heavily than they should. - bias for the familiar: don’t confuse familiarity with knowledge - optimistic (biological default state) / pessimistic bias (rational state) - herd instinct (beliefs of safety, collective rationalisation) outcome/hindsight/confirmation bias	Hubris (refers to overinflated egos, which can lead to lose sense of reality and overconfidence) - take things personally (the market does not know you exist) - overbearing pride, confidence, illusion of control - loss aversion, fear of uncertainty - greed and illusion of control
Imperfect accumulation of facts - Anchoring on irrelevant data: avoid information overload - Projecting immediate past into distant future - Overestimating the likelihood of events based on recent memorable events - Misunderstanding randomness: seeing patterns that do not exist - More information does not mean more accuracy	Heuristics (improper use of short cuts and „rules of thumbs“) - pavlovian reflexes - narrow framing - anchoring - use of intuition